Start-Ups, entrepreneurs and small business owners, be careful how you classify your workers. Think you can simply classify a worker as an independent contractor and avoid paying taxes? Think Again. Merely classifying a worker as an independent contractor does not in fact make the worker an independent contractor. It’s the substance of the relationship, not the title that governs the worker’s status.
Costly legal consequence can arise by misclassifying a worker as an independent contractor. If the US Department of Labor, the IRS or the courts reclassify a worker as an employee, then the employer is retroactively liable for federal and state income tax, Social Security tax, Medicare tax, and federal unemployment taxes. Such a determination can financially crush a business. Owners can also face personal liability.
In determining whether a worker is an independent contractor or an employee, the IRS uses the 20-Factor Test, commonly known as the “common law” test, to determine the degree of control the business has over the way the work is performed. If the business exercises too much control, then the worker is classified as an employee. The IRS examines three categories of evidence closely – behavioral controls, financial controls, and the relationship of the parties.
So if your business is considering classifying a new worker consider the following three categories before you haphazardly label the worker as an independent contractor.
Behavioral Controls. If your business has a right to direct and control what work is accomplished and how the worker does the work, then the worker is likely an employee. Such behavioral controls include telling the worker when, where and how to work, what tools or equipment to use, where to purchase supplies and services, what work must be performed by a specified individual, and what order or sequence to follow.
Financial Controls. The IRS also examines whether your business has the right to direct and control the economic aspects of the work. Such financial controls including (1) whether the worker must own or rent costly equipment to do the work, (2) whether the worker is reimbursed for expenses, (3) whether the worker has the freedom to make decisions that impact his profits or losses.
Relationship of the Parties: Under this category the IRS examines the working relationship between your business and the worker. Facts considered include (1) employee benefits provided, (2) written contracts describing the relationship between the parties, (3) the permanency of the relationship, (4) discharge/termination, and (5) regular business activity.
Even if the IRS determines that a worker should be classified as an employee, Section 530 of the Revenue Act of 1978 provides a safe harbor test that provides a business relief from federal employment taxes, penalties and interest. To qualify for Section 530 relief, the business must have:
- Consistently treated the workers (and similarly situated workers) as independent contractors;
- Complied with the Form 1099 reporting requirements with respect to the compensation paid the workers for the tax years in issue; and
- Had a reasonable basis for treating the workers as independent contractors. To meet the “reasonable basis” test, there are four categories of authority that may be relied upon as a basis: (a) federal judicial precedents and administrative rulings; (b) a prior audit of the taxpayer; (c) industry custom; and (d) a catch-all “other” reasonable basis.
The IRS is aggressively pursuing reclassification of misclassified workers. Start your business off correctly, if there is uncertainty, then play it safe and either (1) treat the workers as an employee, or (2) speak with your business/employment law attorney or accountant, or (3) request a determination from the IRS by filing a form SS-8 (“Determination of Employee Work Status for Purposes of Federal Employment Taxes and Income Tax Withholding”).
If you believe your business has misclassified a worker, then the IRS is offering an amnesty program (“Voluntarily Classification Settlement Program”) that will allow employers to voluntarily reclassify their workers from independent contractors to employees. Talk to your business/employment law attorney or accountant about the amnesty program.
Looking for additional information on Employee v. Independent Contractor? The IRS has a plethora of information here.
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